Spotlight on In re Fair Finance Co., 834 F.3d 651 (6th Cir. 2016)

IN BRIEF

Contract term alterations sometimes need to be classified as either amendments or novations.

Textron was the lender to Fair Finance Company, which turned out to be the operator of a Ponzi scheme.

The Sixth Circuit might have wanted to keep an arguably tainted lender from propping up a Ponzi scheme.

When the parties to a contract agree to alter the contract’s terms, the common law sometimes needs to classify the change as either an amendment or a novation, and this classification depends heavily on the intent of the parties. In this case, a trustee in bankruptcy convinced an appellate panel to indulge in unwarranted speculation about the parties’ possible intent to novate, thereby forcing a lender through a trial on the merits on whether its security interest should be avoided.

Textron Financial Corp. was the lender to Fair Finance Company, which turned out to be the operator of a Ponzi scheme. The lending transaction involved two sequential sets of loan documents: the first was executed in 2002, and the second—describing itself as an amendment and restatement of the first—was executed in 2004. During the interim, Textron had become aware of at least some of Fair Finance’s misdeeds, and after 2004 Textron was paid off in full. Later, as part of an involuntary bankruptcy proceeding, the trustee argued that the security interest provided by the 2004 loan documents was an actual fraudulent transfer. (The statute of limitations for a constructive fraudulent transfer cause of action had already passed, held the court, in a departure from other recent rulings.) To prevent the collateral from being held excluded from the UFTA’s definition of an “asset” that is subject to “transfer,” the trustee argued that the 2004 documents were a novation of the 2002 documents, rather than a mere amendment thereof, meaning that the collateral was not already encumbered by the lien of the 2002 documents. Textron moved to dismiss the trustee’s claim, and the district court (acting on a withdrawal of the reference) granted Textron’s motion, holding that the 2004 documents were an amendment rather than a novation as a matter of law. The Sixth Circuit reversed, finding a triable issue of fact on the parties’ intent to novate.

The grounds upon which the Sixth Circuit found this a triable issue of fact were weak. First, the 2004 documents provided that they constituted “the entire agreement of [the parties] relative to subject matter hereof.” This clause is a routine measure to prevent the undermining of the agreements by parol evidence, and accordingly should not be considered evidence of a terminating of the 2002 documents. Next, the 2004 documents included their own promissory note and personal guarantees rather than relying on the ones from 2002. But this appears to have been an instance of careful although duplicative documentation, engaged in to avoid interpretive questions that otherwise might have arisen about the continued efficacy of the 2002 note and guarantees. And third, and relatedly, the court found it potentially probative of novation that the 2004 documents were entered into on the very date that the 2002 documents expired. Yet this fact more readily supports – if anything – an intent to amend rather than an intent to novate: after all, with the 2002 documents coming to an end under their own terms, the parties had no need to terminate them.

The Sixth Circuit also faulted Textron’s lawyers for, in effect, not using both a belt and suspenders. The district court, in its opinion below, had found some support in a Florida case, In re TOUSA, Inc., 2011 WL 1627129 (S.D. Fla. March 4, 2011), in which a second set of documents had explicitly recited the parties’ intent that the lien of a first set would remain in full force and effect. By contrast, noted the Sixth Circuit here, the 2004 documents in this case had no such clause. It is troubling that the court found fault with the documentation for omitting this single clause (which concededly would have been a helpful inclusion), while at the same time misunderstanding the clauses that the documentation did carefully include. More fundamentally, avoidance-of-doubt clauses like the one in TOUSA are called “belt and suspenders” for a good reason: the extra clause, like the extra clothing device, is there to make sure that even if one or the other somehow doesn’t do its job, the pants will still stay up.

The point of a novation is typically to substitute one party for another. (For example, an obligee may agree to a novation in which an original obligor is discharged and a delegate commits to perform instead.) In this two-party setting there is no apparent reason why Textron, which clearly benefited from good legal advice and would have appreciated the importance of a continuing security interest, would have actually intended to novate rather than amend. Moreover, as a matter of sound jurisprudence, the distinction between novation and amendment should probably be ignored altogether on facts like these, for even if it is possible to conceptualize an instant of time elapsing between the discharge of one security interest and the attachment of the second, a technicality such as that is not a reason for judicially triggering momentous substantive consequences. Of course, the Sixth Circuit might have wanted to keep an arguably tainted lender from propping up a Ponzi scheme and then walking away from all of the losses; but other viable causes of action in this case, including civil conspiracy and equitable subordination, would have been much more appropriate vehicles for imposing losses on Textron. Perhaps, on remand, the district court would stick with its initial finding that the parties intended to amend rather than novate; but even in that event, this Sixth Circuit precedent will cast an unnecessary shadow over future perfectly sound transactions.